By: Russ Kamp, Managing Director, Ryan ALM, Inc.
The start to 2022 hasn’t been great unless you are a long-suffering Mets Fan – great 5-run rally in the 9th to win last night. But I digress. It has been a very challenging environment for our capital markets, which usually means that Pension America is suffering, too. But is that the case this time? The best (most ideal) environment for Pensions is one in which interest rates are rising (liabilities down) and asset levels are flat to up. We haven’t experienced that scenario in quite some time, as we’ve lived through a protracted fall in US interest rates that has harmed pension funding for decades.
Corporate pension sponsors appreciate this fact as FASB mandates a liability discount rate that is market-price based, unlike GASB’s accounting standard that permits public pension systems to utilize the return on asset (ROA) assumption for the discounting of their pension liabilities. This masking of the true level of pension liabilities has been harmful in that decisions related to benefits, contributions, and asset allocation have been made with less than accurate economic information.
Fortunately, in 2022 the US interest rate rise has had a greater impact on a plan’s liabilities than the markets have had on plan assets given the longer average duration of pension liabilities. As we reported in the Ryan ALM Q1’22 Newsletter, plan assets outperformed plan liabilities by roughly 7.2% when using FAS AA Corporate discount rates. We’d already been encouraging plan sponsors to take some risks off the table to preserve the funding gains that had been achieved in 2021 given very strong (unsustainable) market returns. With the continuing improvement in the average plan’s funded status through March 31, 2022, it becomes even more imperative that these gains be preserved.
One easy way to achieve this outcome is to migrate longer maturity fixed income portfolios from a return-seeking mandate to one that cash flow matches pension liabilities chronologically from the next month as far out as the current allocation will permit. This ensures that the fixed income assets will have a shorter duration than the plan’s duration of the liabilities, which is generally somewhere from 10-15 years depending on the maturity of the plan’s workforce. Importantly, a cash flow matching portfolio will ensure that assets and liabilities will move in lockstep with each other stabilizing the funded status for that segment of the portfolio.
If rates continue to rise in a secular trend for many months, long-maturity bonds and pension liabilities will go down in present value significantly. Most total return-focused bond portfolios look like their index benchmark with a sizable amount in maturities longer than 10 years. Cash flow matching is skewed to a much shorter maturity/duration profile which will be much less interest rate sensitive thereby outperforming not only current bond index benchmarks but liabilities as well. We’ve seen the impact of falling rates and falling asset values (’00-’02 and ’07-’09) on pension funding. That combination can be devastating. Fortunately, 2022 hasn’t produced such a combination. Our current scenario of higher rates could be the solution to funding liabilities at lower costs and enhancing the funding status if we transfer from a total return focus on bonds to a cash flow match focus of liabilities chronologically.
Do you know how your plan’s liabilities have performed? If not, call us. We will be happy to provide you with the appropriate insights through our Custom Liability Index (CLI).